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By Lowell D. Yoder, Esq. McDermott Will & Emery LLP, Chicago, IL
Recently-issued temporary regulations provide helpful guidance concerning the limits on the application of the Subpart F branch rules to create foreign base company sales income (“FBCSI”). They provide that the sales branch rule does not create a related-person transaction when a CFC that sells products that it does not manufacture carries on in one branch location all purchasing and selling activities, and, in addition, that the sales branch rule does not apply when the products sold are manufactured by the CFC in a branch. In addition, the temporary regulations clarify that the manufacturing branch rule does not apply when all purchasing, selling, and manufacturing activities are carried on in one branch location.1
Under Subpart F, income derived by a CFC from the sale of products is included in the gross income of its U.S. shareholders currently if it falls within the definition of FBCSI.2 The general definition of FBCSI does not apply where the CFC does not purchase the products from or on behalf of, nor sell the products to or on behalf of, a related person. In addition, FBCSI does not include income derived from the sale of products manufactured in, or sold for use in, the CFC's country of organization, nor income derived by a CFC from the sale of products that it manufactured.3
A CFC that qualifies for one of the above exceptions may nevertheless have FBCSI under the branch rule. The regulations apply the branch rule where a CFC carries on purchasing, selling, or manufacturing activities outside of its country of organization through a branch or similar establishment, and a tax rate disparity test is satisfied. The tax rate disparity test is met where the CFC's income derived from purchasing or selling activities is taxed at an effective rate that is both less than 90% of, and at least five percentage points less than, the effective tax rate that would apply to such income in the CFC's country of organization (sales branch rule) or in the country where the products are manufactured (manufacturing branch rule).4
If the branch rule applies, then the branch and the remainder of the CFC are treated as separate CFCs for purposes of applying the FBCSI rules. The branch is considered as organized under the laws of the country in which it is located, and each separate CFC is considered as conducting only its own activities. In addition, the purchasing or selling activities generally are considered as performed on behalf of a related person.
The temporary regulations clarify that purchasing or selling activities performed through a branch will not be treated as performed “on behalf of” the remainder where the remainder does not engage in any purchasing, manufacturing, or selling activities.5 Accordingly, the branch rule would not operate to create a related party transaction.
For example, CFCX, a Country X corporation, carries on all of its activities through Branch Y located in Country Y. Branch Y purchases products from unrelated persons and sells the products to unrelated persons. Country X has a 30% effective tax rate but does not tax the income of Branch Y, and Branch Y's income is taxed at a 5% rate in Country Y, meeting the tax rate disparity test. Accordingly, Branch Y is treated as a separate CFC organized in Country Y for purposes of applying the FBCSI rules. Nevertheless, since the remainder of CFCX does not engage in any purchasing, selling, or manufacturing activities, under the temporary regulations Branch Y is not treated as purchasing or selling the products on behalf of the remainder CFC. Therefore, Branch Y's sales income is not FBCSI because it does not purchase products from, nor sell products to, a related person.6
It should be noted, however, that the sales branch rule can result in FBCSI even where the “on behalf of” treatment does not apply. For example, assume Branch Y purchases the products it sells from related persons, but CFCX does not have FBCSI under §954(d)(1) because the products are manufactured in Country X (where CFCX is organized). As indicated above, the branch rule applies to treat Branch Y as a separate Country Y corporation, even though CFCX conducts all of its purchasing and selling activities in Branch Y. Thus, the sales income derived by Branch Y would no longer qualify for the same-country-of-manufacture exception. Since Branch Y purchases the products from a related person, its sales income would be FBCSI to the extent the products are sold for use outside Country Y.7
Branch Y may acquire raw materials and components from related and unrelated persons and physically manufacture products in Country Y, and then sell the products to related and unrelated customers. CFCX's income should not be FBCSI under the general rule of §954(d)(1) because it qualifies for the manufacturing exception. In addition, as discussed below, the purchase or sales branch rule should not apply because the products are manufactured in a foreign branch.8 Furthermore, Branch Y's income is not subject to the manufacturing branch rule because it does not apply to income derived in the location where the products are manufactured. In any event, even if the branch rule applied, the sales income derived by Branch Y, treated as a separate CFC, should qualify for the manufacturing exception and the same-country-of-manufacture exception.9
Alternatively, Branch Y may have an unrelated or related contract manufacturer physically manufacture the products on its behalf. Under one scenario, Branch Y may purchase finished products from an unrelated contract manufacturer and sell the products to unrelated persons. Under a second scenario, Branch Y may acquire raw materials and components from unrelated suppliers, consign them to a related contract manufacturer to manufacture the products, and then sell the finished products to unrelated persons. Under both scenarios, §954(d)(1) should not cause CFCX's income to be FBCSI because it does not purchase products from, nor sell products to, a related person. Furthermore, while Branch Y may be treated as a separate CFC under the branch rules, as described above it is not treated as purchasing or selling products on behalf of the remainder, because the remainder is not performing any purchasing, selling, or manufacturing activities. Therefore, Branch Y's income should not be FBCSI under the branch rules because it does not buy products from, nor sell products to, related persons.10
Under the regulations, Branch Y is considered as manufacturing the products it sells if it substantially contributes through the activities of its employees to the manufacture of the products pursuant to a contract manufacturing arrangement, and the contract manufacturer physically manufactures the products.11 This definition of manufacturing applies to both buy-sell and consignment manufacturing arrangements.12 If this definition of manufacturing applies by virtue of the activities of Branch Y's employees performed in Country Y, the same analysis above concerning physical manufacturing in a branch applies, such that Branch Y's sales income should not be FBCSI, even if it engages in related person transactions.13
The branch rules do not take into account activities of the CFC other than purchasing, selling, or manufacturing activities. For example, financing or licensing income derived in a different location by the CFC is not subject to the branch rule. In addition, financing or licensing activities carried on in the remainder should not cause the “on behalf of” construct to apply under the sales branch rule.14
The temporary regulations also expressly provide that the sales branch rule does not apply when the product sold is manufactured in a branch of the CFC. Rather, only the manufacturing branch rule may apply. Accordingly, if the tax rate imposed on the income derived in the sales location does not meet the tax rate disparity test with respect to the manufacturing location, then the branch rule does not apply, even if the tax rate disparity test would be met with respect to the remainder.15
For example, assume a Dutch CFC owns an Irish company and a Swiss company, both of which are disregarded as separate entities for U.S. tax purposes. Products are manufactured by the Irish company and sold to the Swiss company for resale to customers. The effective tax rate in the Netherlands is 25%, in Ireland 12.5%, and in Switzerland, a ruling rate of 8%. The Dutch CFC has a manufacturing branch in Ireland and a sales branch in Switzerland. The manufacturing branch rule would not apply, however, because the rate of tax imposed on the Swiss sales income (8%) is an effective rate that is not less than 90% of, nor five percentage points less than, the effective tax rate that would apply to such income in Ireland (12.5%), the country where the products are manufactured. In addition, while the tax rate disparity test would be met when comparing Switzerland to the Netherlands, the sales branch rule does not apply because the products are manufactured in a foreign branch. Accordingly, the branch rules have no application under these facts.
As described above, sales income derived in the location where the products are considered as manufactured is not FBCSI under the branch rule. For purposes of applying the manufacturing branch rule, manufacturing activities carried out in locations where the tax rate disparity test is not met are attributed to the sales location. Accordingly, if activities taking place in the sales location and all locations where the tax rate disparity test is not met satisfy the definition of manufacturing (e.g., substantial contribution manufacturing), then the income derived by the sales location should not be FBCSI because it qualifies for the manufacturing exception.16
In sum, the temporary regulations are helpful in clarifying that the “on behalf of” construct in the sales branch rules does not apply to a CFC distributor where the CFC does not engage in any purchasing or selling activities outside of the branch with respect to the particular products sold. Accordingly, the unrelated-to-unrelated exception is available to the purchase and sale of finished products by a branch, and applies to contract manufacturing arrangements with a branch where there is no related person transaction. Furthermore, the FBCSI rules do not apply to products manufactured and sold by the same branch, whether physically manufactured or manufactured under the substantial contribution definition of manufacturing (taking into account activities in other countries where the tax rate disparity test is not met). Finally, the sales branch rule does not apply when the products sold are manufactured in a branch of the CFC.
This commentary also will appear in the June 2009, issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Yoder, 928 T.M., CFCs--Foreign Base Company Income (Other than FPHCI), and in Tax Practice Series, see ¶7130, U.S. Persons -- Foreign Activities.
1 T.D. 9438, 73 Fed. Reg. 79334 (12/29/08), as corrected at 74 Fed. Reg. 11843 (3/20/09). The regulations are effective for taxable years beginning after June 30, 2009, but taxpayers may elect to apply the regulations to all open years. See also Proposed Regulations, REG-124590-07, 73 Fed. Reg. 10716 (2/28/08), as corrected at 73 Fed. Reg. 20201 (4/15/08).
2 §954(d); Regs. §1.954-3.
3 Regs. §1.954-3(a)(2), (3), & (4).
4 Regs. §1.954-3(b).
5 Regs. §1.954-3T(b)(2)(i)(b) and (ii)(b). SeePreamble to Proposed Regulations, 73 Fed. Reg. at 10721 (“Section 1.954-3(b)(2)(i)(b) and (ii)(b) are intended to apply only to purchasing or selling by a branch with respect to personal property manufactured, purchased, or sold by ’the remainder of’ the CFC…”).
6 Regs. §1.954-3T(b)(4), Ex. 3. Since the remainder is the only entity, it legally would enter into contracts with the suppliers and customers, generally on behalf of its branch. That fact does not change the analysis in the example. It may be desirable to have purchase and sales contracts executed by employees of the branch in the branch location. The facts are particularly compelling when all revenues derived from selling the products are reported by the branch.
7 For additional discussion concerning the relationship of the FBCSI exceptions to the branch rules, see Yoder, “Code Sec. 954(c)(6) and the Same Country Rules for Sales and Services Income,” 6 J. ofTax'n of Global Trans. 3 (Fall 2006); Yoder, “Same-Country-of-Manufacture Exception to Subpart F Sales Income,” 38 Tax Mgmt. Int'l J. 240 (4/10/09).
8 Regs. §1.954-3T(b)(1)(ii)(c)(1).
9 Regs. §§1.954-3(a)(2), (4), -3T(b)(2)(ii)(e); see also TAM 8509004 (11/23/84) and PLR 8645062 (8/12/86).
10 Regs. §1.954-3T(b)(4), Ex. 3.
11 See Yoder, “Final and Temporary Subpart F Contract Manufacturing Regulations,” 35 Int'l Tax J. 3 (March - April 2009).
12 Regs. §1.954-3(a)(4)(iv).
13 Regs. §1.954-3T(b)(4), Ex. 3.
14 In addition, purchasing, selling, or manufacturing activities carried out in other locations with respect to different products should not be taken into account.
15 Regs. §1.954-3T(b)(1)(ii)(c)(1); see Preamble to Temporary Regulations, at 79342.
16 In addition, if the aggregate of such activities is “demonstrably greater” than the manufacturing activities performed in all locations that meet the tax rate disparity test, the manufacturing branch rule does not apply. Regs. §1.954-3T(b)(1)(ii)(c)(3)(iii), (b)(4), Ex. 9.
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